Fragile? Not Us, Says Turkey, Vying to Win Back Investors

By Jeremy Kahn and Mehul Srivastava -
May 6, 2014

Bloomberg Markets Magazine

From the window of his construction trailer, Murat Sarayli has a prime vantage point on the promise and perils of the Turkish economy. Outside, sparks cascade from welding torches as workers labor to complete the steel skeleton of a $350 million hotel and conference center. Jets pass overhead, approaching and leaving Istanbul Ataturk Airport, less than a mile away.

It’s what those planes carry that keeps Sarayli, the 47-year-old vice president of Sarayli Group, a family company with interests in hotel management, real estate development and commodities trading, optimistic about building 800 hotel rooms and a facility for 3,000 convention goers.

Aboard the outbound flights, he says, are Turkish executives and entrepreneurs heading for Central Asia, the Persian Gulf and Africa. Where they go, Turkish goods follow. That in turn means more jobs for factory workers back home. The inbound flights carry tourists, 39 million of whom visited Turkey last year -- a number that’s been growing at an average of more than 10 percent annually since 2002.

That’s the promise, Bloomberg Markets will report in its June issue.

As for the perils, Sarayli acknowledges that the complex rising behind him was conceived in giddier times. In 2010 and 2011, Turkey’s economy was surging ahead at an annual rate of close to 9 percent, capping 10 years of almost continuous expansion. Today, the pace of growth has been halved, and it is projected to slacken further, to 2.6 percent for 2014, according to the median estimate of economists tracked by Bloomberg.

Fragile Five

The country’s current-account deficit has risen to almost 8 percent of gross domestic product -- bad enough to earn Turkey a place among Morgan Stanley’s Fragile Five, the bank’s moniker for the emerging-markets countries whose economies are most vulnerable to higher world interest rates.

During the past year, Turkey has been walloped by civic unrest, political uncertainty, a massive corruption scandal and the U.S. Federal Reserve’s decision to begin scaling back its program of quantitative easing. Investors don’t like any of this. The benchmark Borsa Istanbul 100 Index (XU100) began to slide after May 30, 2013, when the violent eviction of environmental campaigners occupying a city park in Istanbul provoked widespread protests against the government of Prime Minister Recep Tayyip Erdogan.

From May 30 through March 30, the Borsa fell 21 percent and the Turkish lira declined 14 percent. From May 30 through the end of February, foreign investors sold $500 million more in Turkish stocks and $2.8 billion more in Turkish bonds than they purchased, according to data from Turkey’s central bank.

‘Not a Disaster’

Sarayli knows about all of this. Yet he remains optimistic about the long-term promise of a country where half the population is under 30 and where a large middle class has taken root.

“A couple of years of slow growth are not a disaster,” he says. “A correction? Yes, that could happen. But I don’t see a crisis.”

If you want to understand the soaring aspirations that made Turkey a favorite of investors, and also the treacherous economic and political conflicts beneath the surface, visit some of the country’s massive building projects. The share of GDP attributed to construction doubled to 7 percent in 2013 from 3.5 percent in 2002, when Erdogan’s Justice and Development Party, known by the Turkish acronym AKP, came to power.

Istanbul’s skyline is a testament to this boom: Ancient minarets now compete with thrusting glass-and-steel towers and construction cranes that foreshadow more to come. Turkiye Garanti Bankasi AS (GARAN) estimates that about $100 billion in government-contracted infrastructure projects will be completed over the next five years.

Public-Private Partnerships

These projects are being built as public-private partnerships, with companies paying the government for the right to build and then lease or operate them. Financing comes from state-owned banks as well as private local and foreign investors. In a move to help infrastructure companies secure financing, Turkey’s Treasury agreed in mid-April to guarantee the debt of all public-private partnerships with costs in excess of 1 billion liras ($469 million).

An hour’s drive northeast of Istanbul, close to the Black Sea coast, sits the small village of Agacli, where black water buffalo lumber through the morning mist to graze on scrub-covered hills. This land is slated to be expropriated, then leveled to make way for Istanbul’s third airport, scheduled to open by 2019.

‘Crazy, Magnificent’

Like many of Erdogan’s favorite projects -- including a bridge across the Bosporus strait and a $12 billion shipping canal paralleling the Bosporus that Erdogan himself referred to during the 2011 parliamentary campaign as his “crazy, magnificent project” -- the airport is of a monumental scale that reflects his great ambitions for his country. Costing $14 billion in construction expenses alone and occupying an area larger than Manhattan, it will be capable of handling 150 million passengers a year, half again as many as Hartsfield-Jackson Atlanta International, currently the busiest airport in the world.

Turkish Airlines, which is 49 percent owned by the government and flies to more international destinations than any other carrier, has said it needs a new Istanbul airport to continue its worldwide expansion. Critics say the project’s size is more about prestige than any business demand.

“These kinds of projects are hubristic in nature,” says Fadi Hakura, a researcher specializing in Turkey at Chatham House, a London think tank. “They are white elephants and are not critical to the prosperity of the Turkish economy.”

‘Mad Turks’

A consortium of five companies, including Limak Holding AS and Cengiz Insaat Sanayi Ve Ticaret AS, Kalyon Insaat Sanayi Ve Ticaret AS, Kolin Construction and Mapa Construction, won the bidding for the airport. The price -- 22.2 billion euros ($29.1 billion) for the right to build the facility and operate it for 25 years -- was so high, it left other bidders scratching their heads as to how the winners would find financing or ever make money. Erdogan, in a speech in May 2013, called the five companies building the airport “the mad Turks” before saying, “I’m sure these guys will be very successful.”

There was suspicion in Turkey’s construction sector about the bidding -- the Transportation Ministry altered the tender process a week before bids were due -- and it was heightened late in 2013 after the names of executives from the winning consortium showed up in files posted by unknown sources on Twitter.

Corruption Investigation

The files, according to the tweets, were from a wide-ranging police investigation into government corruption. In what were purported to be transcripts of police audio surveillance and segments of audio recordings, the executives allegedly discussed bribes to a transportation minister and efforts to buy a media group at Erdogan’s behest in exchange for an inside track on infrastructure contracts.

In the wake of the leaks, Erdogan replaced Transportation Minister Binali Yildirim in a cabinet reshuffling on Dec. 25. Yildirim didn’t respond to requests for comment for this story. Erdogan has called some of the audio recordings an “illegal montage,” while saying others depicted “normal” aspects of his job.

Limak deputy chairwoman Ebru Ozdemir said in response to e-mailed questions about the airport that the “tender process was executed in a transparent and accountable framework.” She also said the project was economically feasible. “We did our homework before the tender process, and we are comfortable with the price,” she wrote.

Municipal Elections

Erdogan’s political foes were banking on the corruption probe, the details of which leaked out day after day over social media, weakening him. It didn’t. Nationally, the AKP won 46 percent of the vote in municipal elections on March 30, a gain on the 39 percent it had won in the previous round of local elections, in 2009. In early May, a Turkish prosecutor dropped an investigation into real estate corruption that had been one of the three related graft probes rattling the Turkish government, according to a report in the Turkish newspaper Hurriyet.

As foreign investors fled Turkey, a group of contrarians doubled down.

Since mid-December, Reid has added to his positions in Turkey; he notes that the valuations in some sectors -- including banking, in which many companies now trade at close to book value -- haven’t been this attractive since 2009.

Competitive Advantages

Gary Greenberg, an emerging-markets money manager at London-based Hermes Fund Managers, an asset-management company with 26 billion pounds ($44 billion) under management, has also increased his holdings in Turkey.

Some of these bets look prescient: As of April 24, the Borsa Istanbul 100 was 25 percent above its March 3 low. The MSCI Emerging Markets Index rose 5.6 percent during the same period.

The average Turk is better off now, in the 12th year of the Erdogan government. Per capita income, expressed in constant 2005 U.S. dollars, rose to $8,500 in 2012 from $5,900 in 2002. But Turkey’s rank among countries by this gauge, 67th, has barely changed during the past decade, according to the International Monetary Fund.

‘Middle-Income Trap’

Instead of investing in the high-skilled jobs and high-tech manufacturing and services that could give Turkey the escape velocity to reach the upper echelon of world economies, the country has relied for growth on consumer spending and construction, says Murat Ucer, an Istanbul-based economist at research firm GlobalSource Partners.

Household consumption now accounts for 67 percent of GDP, and consumers have borrowed heavily to fund that spending. Household debt exceeds 50 percent of disposable income, up from 4.7 percent in 2002. Turkey’s domestic savings rate declined from 23 percent of GDP in the 1990s to 12.7 percent in 2010, the lowest figure since 1980, according to the World Bank. It’s the opposite of what should be happening, Hakura says, noting that most successful emerging markets have savings rates greater than 25 percent of GDP.

Current-Account Deficit

Government debt has fallen dramatically during Erdogan’s tenure, from 74 percent of GDP in 2002 to less than 37 percent today. Foreign corporate borrowing, however, has ballooned: Total external debt has risen to $388 billion from $125 billion in 2002. A third of that debt comes due in the next 12 months, meaning Turkey’s businesses must either pay their bondholders or roll over the debt while the economy is slowing. About half of Turkish corporate debt is denominated in a foreign currency, leaving the issuing companies exposed to declines in the lira.

If there is a single number that encapsulates investors’ concerns about the Turkish economy, it is the country’s current-account deficit, the gap between the value of Turkey’s imports and its exports. That chasm must be bridged with borrowed money. And the more a country borrows, the more its currency comes under pressure, leading in some cases to a rapid and economically devastating devaluation -- a balance of payments crisis.

Central Bank

Turkey’s central bank has been trying to stave off this sort of crisis since January, when it sold $5.8 billion in foreign currency to prop up the lira. Then, in a midnight meeting on Jan. 28, the bank more than doubled the weekly repo rate, the rate at which it lends money to commercial banks, to 10 percent from 4.5 percent, and hiked the overnight lending rate to 12 percent from 7.75 percent. It did so despite political pressure from Erdogan to keep the rates low.

Goldman Sachs Group Inc. economist Ahmet Akarli says the central bank waited too long. Inflation, while much lower than when Erdogan first came into office -- it was above 30 percent when Turks went to the polls in 2002 and gave the AKP its majority -- is running at more than 8 percent annually.

At least one major hedge-fund firm -- Emerging Sovereign Group LLC, which has $5 billion under management and is owned by private-equity colossus Carlyle Group LP -- is betting that the bank will lose its battle to defend the lira.

Lasting Damage

“Turkey had all the ingredients for a textbook balance of payments crisis, and it is quickly playing out as we had expected,” New York–based ESG wrote to its investors in January. Since then, Turkey has reported a smaller trade deficit than forecast and the lira has stabilized.

A balance of payments crisis would be a calamity. And it isn’t the only reason to worry about lasting damage from the past few months of political infighting in Turkey, Ishak Alaton says. Alaton is chairman of Alarko Holding AS (ALARK), which he co-founded in 1954 and which today has interests in energy, construction and tourism and 1.2 billion liras in annual revenue. A grandfatherly figure at 86, he likes to watch ships transiting the Bosporus from his office atop a hill in the affluent Istanbul neighborhood of Ortakoy, and he takes a similarly long view of his country’s development.

Corruption, he says, is nothing new. “It’s sometimes more visible, sometimes less,” he says with a shrug. What is new and disturbing, he says, is the way the scandal has damaged the rule of law.

Lasting Damage

The Erdogan government’s response to the corruption probe -- transferring or demoting more than 5,000 police officers and prosecutors in a largely successful effort to derail the investigation -- risks lasting damage, Alaton says.

“Once you lose confidence in the judiciary, it is not easily repaired,” he says. “Just one man trying to save his own skin is destroying the whole fabric that has been woven in the past 90 years of the republic.” Alaton fears foreign investors will shun Turkey if the rule of law frays further.

Muharrem Yilmaz, president of Turkish industry group Tusiad, which represents Turkish conglomerates, has voiced similar concerns.

“A country where the rule of law is ignored, where the independence of regulatory institutions is tainted, where companies are pressured through tax penalties and other punishments, where rules on tenders are changed regularly, is not a fit country for foreign capital,” Yilmaz said at a conference of business executives on Jan. 23. Erdogan subsequently branded Yilmaz a traitor.

Tax Penalties

The prime minister has a history of using his bully pulpit and state power to go after opponents declared or perceived. In 2013, for the second consecutive year, Turkey jailed more journalists than any other country, according to the New York–based Committee to Protect Journalists. After newspapers owned by media company Dogan Yayin Holding AS (DYHOL) criticized Erdogan, authorities fined the company $2.5 billion for unpaid taxes.

When a hotel owned by Koc Holding AS (KCHOL), Turkey’s largest public company, opened its doors to a crush of protesters fleeing tear gas and water cannons last spring, Erdogan accused Koc of sheltering criminals. Tax authorities subsequently raided two Koc energy companies, and another Koc subsidiary lost defense contracts.

More Elections

The municipal elections in March calmed the markets, confirming as they did that Erdogan would retain his grip on power. Turkey still has to get through two more elections, however. The country’s first direct election for president is scheduled for Aug. 10, and Erdogan, who is prohibited by AKP rules from taking a fourth term as prime minister, has suggested he may run. The president’s role is largely ceremonial -- or it is for now. New parliamentary elections are scheduled for June 2015.

Back in his construction trailer near Ataturk Airport, Murat Sarayli says he doesn’t expect an easy year. Yet his faith in Turkey’s long-term prospects remains undimmed.

“Once the elections pass, I am a firm believer that Turkey will go back to its growth agenda,” he says.

That’s not the same thing as resolving what Chatham House’s Hakura calls “the underlying fundamental drags to the Turkish economy.” That, Hakura says, would require reforms to improve education, increase women’s participation in the workforce, privatize more state-owned companies and improve corporate governance and the rule of law. None of which Erdogan shows any indication of doing.

Turkey optimists see the imminent end of a very tough period. Pessimists say the bottom hasn’t yet been found.